Exchange Rate 2 Essay, Research Paper
International Economics at Shippensburg University
EXCHANGE RATE DETERMINATION
What are the factors that cause supply and demand for exchange to change? There are
several theories on this topic.
Some theories attempt to explain short run movements in exchange rates while others
study long run movements. The determinants of equilibrium exchange rates in the short run
and in the long run tend to be different.
1. Balance of Payments Approach to Exchange Rate Determination
This approach emphasizes the flows of goods, services, and investment capital that
respond gradually to real economic factors such as GDP. It predicts that exchange rate
depreciation for countries with deficits in their current accounts and appreciation for
countries with surplus.
Recall D for FX involves all debit transactions in the BPs. S involves all credit transactions.
D is downward sloping and S is upward sloping.
S and D for FX reflect changes in the domestic D for foreign goods and services and in the
foreign D for domestic goods and services. These, in turn, are determined by
macroeconomic conditions at home and abroad.
relative prices of domestic and foreign goods
(e.g.) If U.S. inflation rate is higher than U.K.? D for British goods goes up; D for
American goods down; D for FX up, S down; $ depreciation.
the level of real income within countries
(e.g.) If U.S. income grows faster than U.K.? American D for British goods goes up
(why?); D for FX goes up; S goes down; $ depreciates.
others including resource accumulation, harvest conditions, strikes, market
structure, and commercial policy.
International capital movement also affects exchange rates in the short run. In general,
easy credit and relatively low short-term interest rates lead to exchange rate depreciation
for a country. (Short term interest differential is a key determinant of international capital
(e.g.) The case where U.S. interest rate is relatively lower than U.K. due to the fed’s
easy monetary policy. American investors will want to invest in London; D for pound
increase; British investors will want to avoid $ denominated assets for investment; S
of pound goes down; the result? $ depreciates.
The balance of payments approach is no longer popular. It can’t explain short run volatility
of exchange rates, as it emphasizes flows of funds that adjust gradually over a period of
time. It is also difficult to decide which BP account to use to predict exchange rate
2. The Monetary Approach to Exchange Rate Determination
This approach views the money supply and money demand at home and abroad as major
determinants in exchange rate movements. It suggests that an increase in the domestic
money supply causes the home currency to depreciate, while an increase in domestic
money demand causes it to appreciate.
The aggregate money supply is controlled by central banks.
The aggregate money demand is a function of real income, prices, and interest rates.
How an increase in money supply leads to depreciation of home currency: As money supply
goes up, domestic spending and income rise; imports increase; D for FX goes up. Also, as
money expands, interest rate goes down; Americans invest abroad; D for FX increases.
The result: $ depreciates.
Show how an increase in money demand will lead to an appreciation of home currency.
The monetary approach suggests that if we can forecast money demands and money
supplies, we can forecast long run movements in exchange rates.
The monetary approach is criticized for paying too much emphasis on money while ignoring
other important variables. In addition, empirical support of the theory has been mixed.
3. Expectations and Exchange Rates
Day-to-day movements in exchange rates are closely related to people’s expectations.
The following are examples of expectations that will lead to appreciation in the yen and a
depreciation in the dollar:
economy will grow faster than the Japanese economy
interest will be lower than Japan’s
inflation rate will be higher than Japan’s
Money supply will grow faster in U.S. than in Japan
All these will, if true, cause $ to depreciate and yen to appreciate.
A graphical illustration of how expectations of future inflation can affect exchange rates:
Start at initial equilibrium. Suppose people expect a depreciation of $ for some
reason (e.g., unanticipated growth in money supply in the U.S.); Americans who
intend to buy goods from Germany will purchase DM before $ depreciates. D for DM
increases (D curves shifts up).
The Germans, having the same expectations, will be less willing to obtain $ whose
value is expected to decline. The supply of DM declines (S curve shifts up).
Both cause the ($/DM) rate to increase now; $ depreciates, DM appreciates. The
expectations are self-fulfilling.
4. The Asset-Markets (Portfolio-Balance) Approach
This approach extends the monetary approach in that it includes domestic currencies to be
one among many financial assets that a nation’s citizens desire to hold (e.g., domestic
currency, domestic securities, foreign securities denominated in a foreign currency, foreign
This approach suggests that stock adjustments among financial assets (reallocating stock
of wealth among assets in various countries) are a key determinant of short term
movements in exchange rates. It maintains that it is mainly through the medium of market
expectations of future returns that exchange rates are affected in the short run. Other
variables such as the CA balance or money supply growth affect exchange rates to the
extent that they influence market expectations.
This theory explains the movements in exchange rates in terms of the D and S of assets
denominated in different currencies.
b. The theory
1) Exchange rates and a nation’s money supply (Ms)
If Ms, value of $ will decline. (e.g. During 1922-23, Germany’s Ms by trillion times
(hyperinflation); value of FX in Germany by trillion times.
Ms is controlled by central banks. (e.g. the Fed)
2) Transaction D for money (Md)
Why would people want to hold money? To buy goods and services. (cf. Other motives for
Md: as an asset, speculation…) Why would people demand FX? To buy foreign goods and
Md is a function of interest rate (r), price level (p) and real income (y). (e.g. When r goes
up, opportunity cost of holding money increases; Md goes down. When p goes up, more
money is needed to buy the same basket of goods; Md goes up. When y goes up, people
demand more goods, and thus demand more money.
Md curve is downsloping. Why? “Given the y level, real Md and r are inversely related.”
What happens to the Md curve when y increases? (Shift to right!)
3) Money market equilibrium
Equilibrium in the money market requires Ms=Md or (Ms/p)=(Md/p). But Md=p*L(r, y) and
(Md/p)=L(r, y) since Md is directly proportional to p. (Why? A 10% increase in p means you
need 10% more money to buy the same basket of goods). Thus, equilibrium requires:
(Ms/p) = L(r, y)
4) Effects of changes in Ms and y on the equilibrium r
(e.g.) Ms goes up, [(Ms/p) > (Md/p) at r]; people find that they are holding more money
their desired level; r declines as unwilling money holders try to lend out some money. “A
nation’s Ms and r are inversely related.”
(e.g.) y (GDP) from y1 to y2; Md curve shift up to right as people want to hold more
money for transaction D; r goes up.
5) Effects of changes in Ms and y on the exchange rates
Consider “world money market” equilibrium: S of money = (M*/M), the relative supply of DM
(the FX in question) to $. (Recall Ms in the U.S. and Germany are fixed at any given time.
Thus, the ratio is also fixed.) D for money = (L*/L), the relative D for DM to $. This Money
demand ratio is a function of (y*/y), (r*/r), expectations, etc.
(e.g.) As the Bundesbank increases the German Ms, (M*/M) goes up, the world Ms curve
shifts to right; e (exchange rate measure in $/DM rate) would go down. “DM depreciation”
(e.g.) As German real income (y*) increases relative to y in the U.S.; (y*/y) will increase,
and D for DM will go up. [(L*/L) increases as people need to hold more DM for transaction
purpose.]; (L*/L) curve shifts up and e goes up (”DM appreciation” or “$ depreciation”)
If y* is a result of government’s expansionary policy, its main effect may be an increase in
imports so that (L*/L) declines as Germans would want to have more $ to buy more from
6) Other determinants of exchange rate
Factors that can shift (L*/L), besides (y*/y), include: (r*-r), expectations, BT
(e.g.) If (r*-r)>0 (i.e., r*>r), more DM will be demanded (why?); (L*/L) will increase and e
goes up (DM appreciation)
(e.g.) If (M*/M) decline is expected, $ depreciation is expected and people would sell $ for
DM before it’s too late. e increases ($ depreciates) today
(e.g.) Government policies toward private assets such as freezing assets, possible
taxation, …. can affect investors’ expectations.
(e.g.) If deficit goes up in the American BT (or CA) balance, FX market would react to
bring down $ value. (why?)
5. Purchasing Power Parity (PPP) Approach
If the value of a country’s currency rises above the level warranted by its economic
conditions, the exporting industries of the country will become less competitive in
international markets and a trade deficit will be likely to follow. It is important, therefore,
for policy makers to have forecasting ability about the equilibrium value of exchange rate if
an effective exchange rate management is desired. In fact, discussion of “overvalued” or
“undervalued” currency assumes that there exists a stable equilibrium exchange rate to
which the value of a currency can be referenced. The purchasing-power parity (PPP)
theory states that the equilibrium value of an exchange rate is determined by the changes
in the relative national price levels. For example, if the U.S. price level rises by 10 percent
over a year while Japan’s price level rises by only 6 percent, then relative PPP predicts
that the dollar will depreciate against the yen by 4 percent. The dollar’s 4 percent
depreciation against the yen just cancels the differential in the inflation rates, leaving the
relative domestic and foreign purchasing powers of both currencies unchanged. The theory
recognizes national price levels and its interaction with exchange rates as a key factor in
understanding why exchange rates can change dramatically over periods of several years.
If valid, the PPP theory can be used to forecast approximate levels to which current levels
should be, given the projection of relative price levels.
The PPP theory has been empirically tested for several countries. Prior studies have shown
that in general the PPP hypothesis is not likely to hold in the short and intermediate runs.
There remains, however, considerable disagreement among researchers concerning PPP in
the long run. For example, Roll (1979) and Adler and Lehmann (1983) were unable to
confirm the validity of longrun PPP while Frankel (1985), Kim (1990) and Abuaf and Jorion
(1990) were able to support it. These and other studies for the test of PPP employed
various statistical methods using different sample periods and frequencies of data.
The Law of One Price and PPP
The law states that in competitive markets free of transportation costs and barriers to
trade, identical goods sold in different countries must sell for the same price when their
prices are expressed in terms of the same currency.
(e.g.) Let e = $2/ , P of a sweater = 20 in London, $50 (or 25) in New York, then the
price in NY is higher; arbitrage would bring NY price down and London price up until the
prices are equal.
Expressing the law in general terms, for any good,
PUS = (e$/ ) x PUK.
Carrying the law to all goods, the equation also states PPP.
The relative version of PPP states that the percentage changes in the exchange rate
between two currencies over a period of time reflect the differences in the inflation rates
of the two countries over the same time period. It asserts that exchange rates and
national prices will adjust in such a way that the ratio of the purchasing powers of two
currencies remains steady. Relative PPP can be represented by the equation
where r is the nominal exchange rate between home and partner country defined as units of
partner country’s currency per unit of home currency, p* denotes the price level of the partner
country, p is that of the home country and k is a constant. Relative PPP indicates that k is
stable in the long run. Testing the validity of PPP statistically entails some modifications of the
equation. First, a random disturbance term needs to be included as the relation in (1) is not
expected to hold exactly. In addition, the coefficient on the price ratio is treated as an unknown
parameter rather than a known constant. (Whitt 1988) Finally an intercept term is usually
included in a linear specification of the PPP equation. The resulting equation is as follows:
where the subscript t denotes the time period t, u is a random error term, a an intercept term
and b the coefficient of the price indexes to be estimated. Both variables, the exchange rate
and the ratio of price indexes, are measured in logarithms. In empirical testing if the coefficient b
is not significantly different from unity, the PPP principle would be confirmed.
There are several practical issues to be resolved in testing the PPP relationship. First, it is
argued that low frequency data are more appropriate for long run PPP. In the absence of
annual data for a substantially long period, this study will use both monthly and quarterly
observations. Second, there are at least three alternative price indexes that can be used
as proxies for the price level: the GNP deflator, the Consumer Price Index (CPI) and the
Wholesale Price Index (WPI). The GNP deflator is regarded as a poor choice since it does
not properly reflect the changes in the average price level while the WPI is biased toward
the PPP hypothesis. The CPI is the primary choice for this study as it is considered to be a
reasonable choice (Layton and Stark 1990) and is more readily available. For a comparison
purpose, WPI series will be also used for the countries for which data are available. Finally,
this study will employ the concept of cointegration to test the PPP hypothesis since the
newly developed method is, as discussed in the following section, considered to be
particularly suitable in examining longrun equilibrium relationships.
The PPP theory has several limitations: The theory overlooks the fact that exchange rate
movement may be affected by capital flows. There is a problem of choosing the
appropriate price index (CPI, PPI, …) and the base year. Government commercial policy
can interfere with the operation of the theory (trade restrictions).
Empirical evidence on PPP is also mixed. For the countries with high inflation rates (e.g.,
Latin America), the theory appears to perform well. However, when inflation differential is
small, factor other than price comparisons can become more important in the determination
of exchange rates. In addition, PPP tends to hold in the long run better than in the short
run, perhaps because time lags in the BP adjustment process and government interference,